Monetary and fiscal policy during the Great Depression

The government plays a very important role in the regulation of a country’s economy by regulating and authorizing the amount in circulation and the amount held by banks and other financial institutions.

This process can be done in two different ways which include monetary policy and fiscal policy (Frank & Bernanke 42). Monetary policy is the process where the government intervenes by administering and controlling the amount of money in the economy using the Central Bank in many countries and the Federal Reserve in the United States.

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This is effected in several ways which include buying of government securities in the open market operations, interest rates, discount window rate and controlling the minimum reserve requirement ratio. Fiscal policy is where the government does not directly affect the supply of money in the economy thus it affects the amount of money by use of taxes and government spending (Friedman and Schwartz 79).

In the 1930s the U.S economy almost collapsed when most civilians lost their jobs and the stock market crashed due to the persistent fall in stock prices which led to increased sale of stocks but with the forces of demand and supply, supply was way greater with no demand. This led to a financial panic since everyone wanted to sell their stocks.

Banks had also invested a large portion of their clients deposits into the stock market which rendered then bankrupt forcing them to close down. People ran to the remaining banks to try and salvage the remaining amounts of money before they could close down. This affected other countries although not as much as it did in neighboring countries. This led to the intervention of the government to restore the economy since unemployment increased at an alarming rate (Bernstein 53).

Many economists especially the classicals advocated for minimal if not all government intervention and claimed that the forces of demand and supply would adjust themselves until the economy was at equilibrium but with government intervention, the forces would be disrupted and slowed down thus, would not work effectively. This theory was overruled by the John Maynard Keynes who developed the Keynesian theory which argued otherwise (Glasner 40).

He proposed government intervention to correct the economies instability especially in the case of correcting inflation and recession. The government through the Federal Reserve uses various tools to affect the economy which mainly focus on the rate of interest prevailing in the market, the amount of money in the economy through money supply and the aggregate expenditure.

The main question to ask is what caused the great depression? It is believed that the crash by the stock market was caused by the stringent monetary policies which were set by the Federal Reserve. Some of the policies were persistent increase in the Fed Funds rate which led to stock market to crash. This led to investors selling their dollars in exchange for gold while others withdrew their funds and exchanged it to other currencies (Bordo et al 78).

The government tried to preserve the value of dollar from depreciating by raising the amount of interest rate which caused further bankruptcy to the businesses.

The proper way to help fight deflation was to adjust the amount of money supply in the economy but instead the Federal Reserve restrained from increasing money supply. As investors withdrew money from banks causing financial plight, others exchanged the dollars to other currencies and invested them in other countries, a move which the Fed did not bother with it thus, led to further decrease in money supply in the economy a process known as contractionary monetary policy.

Money supply dropped dramatically to low levels of up to thirty percent. Instead the Fed should have used expansionary monetary policy where it should have increased the amount in the economy through increase in government spending, reduction in taxes and reducing the interest rate so as to increase the amount of money in circulation (Mankiw 45).

The great depression was tackled by the introduction of new policy makers where Franklin Roosevelt succeeded Herbert Hoover who was blamed for the cause of the depression. Roosevelt stabilized the economy by introducing new policies and rules. Banks that had closed down were reopened once they seemed to be stable enough. He signed the “new deal” to create new programs to combat the great depression into laws which were used to create jobs and provide unemployment insurance (Hall and Ferguson 59).

These programs alone could not combat the great depression alone and so this led to the entry of World War II that helped to create defense related activities. U.S and other countries affected turned to currency devaluation and expansionary monetary tactics in recovery of their economies. U.S recovered later than other countries like the Britain and the Argentina because it did not devalue its currency and abandons the gold standard until 1933 and recovered later on.

Monetary expansion was from the gold inflow into the country from Europe due to the rise in political tension which broke to World War II. Interest rates were lowered and investors encouraged taking up loans since credit was made to be readily available to all (Klein 30).

This stirred up expectations of inflation a sign to fight deflation building confidence to investors that they would earn enough profits and wages to help repay the loans which they were to borrow. Many consumers and businesses responded well and it was evident in the increase in interest sensitive investments such as fixed assets like motor vehicles, machinery and trucks.

Fiscal policy on the other hand was not as much effective as the monetary policy. Taxes were highly increased when the government tried to balance its budget when it reviewed the revenue act of 1932. This was a blow to the recovery as it discouraged spending which was a contractionary process. Many unemployed persons were offered jobs in government projects and farmers encouraged by being paid large amounts of money through the Agricultural Adjustment Administration.

Some of the effects of the recovery from the great depression were human suffering due to the wars. Many were left in poor living standard conditions due to lack of jobs. It led to the end and use of gold standard internationally. Many countries also aborted the system of fixed exchange rate regime and preferred the floating rates although the fixed currency exchange rate system had been brought forward under the Bretton Woods System (Eichengreen 48).

During this period, labor unions were formed and grew drastically as it promoted collective bargaining. This led to the introduction of unemployment compensation and even old age insurance via the Social Security Act.

The Securities and Exchange Commission was established in order to monitor and regulate the stock issues and trading practices. Banking act of 1933 was established which introduced Deposit insurance that helped kill banking plights and panic and also prohibited banks from underwriting or dealing with stocks and securities.

Another effect is that policies led to a decrease in savings both government and private savings, which means that a higher fraction of output would be used to pay the debt thus consumed abroad and less if not any consumed at home (Hansen 89).

The great depression was a very good lesson to the Federal Reserve and other Central Banks in the monitoring and regulation of the economy through the intervention of the government. If the U.S government did not intervene the effects would have been worse according to Keynes, and the economy would have collapsed maybe to worse extent.

Other economists such as the classical learned from Keynes theory and most of them up to date advocate for the intervention of government in stabilizing the economy. The only thing to disagree about is the tools to be used and which one is more effective, appropriate or do not lag. In some cases it is best if both fiscal and monetary policies are used together in order to prevent both inflation and depression.

It also led to the development of new macroeconomic policies which did not exist or were not familiar to the policy makers. In Keynes General Theory of Employment, Interest and Money (1936), he suggested that use of fiscal policies which increased government spending, reduction in taxes and monetary expansions could prevent depression and recover an economy (Temin 22).

Works Cited

Bernstein, Michael. The Great Depression: Delayed Recovery and Economic Change in America, 1929-1939. New York: Cambridge University Press, 1987. Print.

Bordo, Michael D., Claudia Goldin, and Eugene N. White. The Defining Moment: The Great Depression and the American Economy in the Twentieth Century. Chicago: University of Chicago Press, 1998. Print.

Eichengreen, Barry. The Gold Standard and the Great Depression, 1919-1939. New York: Oxford University Press, 1992. Print.

Frank, Robert & Bernanke, S. Principles of Macroeconomics. Boston: McGraw-Hill, 2007. Print.

Friedman, Milton, and Schwartz, Anna . A Monetary History of the United States, 1867- 1960. Princeton: Princeton University Press, 1963. Print.

Glasner, David. Free Banking and Monetary Reform. New York: Cambridge University Press, 1989. Print.

Hansen, Alvin. Full Recovery or Stagnation? New York: Norton, 1938. Print.

Hall, Thomas, and Ferguson, David. The Great Depression: An International Disaster of Perverse Economic Policies. Ann Arbor: University of Michigan Press, 1998. Print.

Klein, Lawrence. The Keynesian Revolution. New York: Macmillan, 1947. Print.

Mankiw, Gregory. Macroeconomics. New York: Worth, 2003. Print.

Temin, Peter. Lessons from the Great Depression. Cambridge: MIT Press, 1989. Print.

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